According to the U.S. Social Security Administration, America’s social security trust fund will run out of gas in the year 2041 (see table). That’s because the U.S. Social Security system is a pay-as-you-go scheme where current income pays most of current payments to retirees. One of the policy levers at the U.S. government’s disposal is to inflate their way out of this predicament by printing money for future retirees when the time comes.
But state and local pension plans enjoy no such privileges. The only source of income for state and local governments is, of course, taxes. That’s why nearly all state and local pension plans are pre-funded, not pay-as-you-go. Nobody wants to have to increase taxes to pay for unfunded pension commitments to municipal workers made years ago.
But as George Pennacchi and Mahdi Rastad of the University of Illinois wrote in a January 2011 paper entitled “Portfolio Allocation for Public Pension Funds“, this introduces a host of issues. For instance, if municipalities are to take a holistic balance sheet-wide view, then the surplus or deficit incurred by the pension fund should be counter-balanced by non-pension surpluses or deficits. In other words, the pension fund should produce an extra kick when governments run a deficit (i.e. the economy’s in recession) and run at a loss when governments are racking in the dough during good times.
Alas, they said: “[M]unicipal governments typically do not incorporate pension fund investment decisions within a single framework for managing their overall balance sheets.” And so a board of trustees is picked and the board delegates authority to staff that are judged primarily on the basis of relative investment returns, not the pension fund’s liabilities and certainly the government’s overall fiscal situation.
That might be one of the reasons for the relentless migration of public funds into equities since the 1950’s.
And that’s why, despite differing volatilities of funding gaps, the volatility of tracking error relative to the fund’s peers remains low in most cases. The chart below from Pennacchi and Rastad’s paper shows that public pension funds tend to “herd.” The volatility of their tracking errors is very low, even though some funds have a relatively stable funding status (left side of scatter plot below) and some have a highly volatile funding status (right side).
The result, as we all now know, is an abysmal funding status. Using data on 125 U.S. state pension plans, Pennacchi and Rastad calculated funding ratios since the Turn of the Millennium.
They also found some interesting differences between plans overseen by boards containing plan participants and those without plan participants:
“The finding that a fund takes more tracking error risk when it has greater participant representation on its Board of Trustees might be explained in a couple of ways. If pension participants are less financially literate than typical Board members, they may be less able to select asset allocations that immunize the plan’s liabilities. Alternatively, participants may intentionally take more tracking error risk to increase the likelihood of a significant pension surplus that will accrue to them in the form of increased benefits or lower employee contribution rates.” (our emphasis added)
They also discovered that recent out-performance might embolden funds to break from the herd, even if their motivations might raise a few eyebrows:
“The positive and statistically significant coefficients on the plan’s prior-year funding ratio and prior investment return indicate that pension funds deviate more from their peers following better performance. Such behavior would be consistent with the positive theory that the pension fund Board and staff maximize their own utility and their compensation is large relative their personal wealth or their personal wealth is invested in primarily risky assets.” (emphasis added)
But at the end of the day, the problem may not be management incentives, but bad accounting standards:
“The portfolio choices of public pension plans that deviate substantially from the liability immunizing strategies may be encouraged by opaque and misleading accounting standards that are divorced from finance theory. Such standards may lead public plans to follow their “traditional” investment strategies of choosing investments with little regard to their true liability risks. The pension fund asset-liability mismatches resulting from these strategies pose a potential burden to taxpayers that will be realized then economic conditions decline and when losses are most difficult to bear.” (emphasis added)
Of course, “focusing on true liability risks” is another way of saying pension plans need to focus on their specific funding needs and not on the performance of their peers. For more on Liability Driven Investing, click here.